United States economic growth has slowed in recent years because of a surprising fall in business investment. Normally
when businesses make increased profits, they increase their investment. However, even though U.S. businesses have been making increased profits in their competition with foreign businesses since the dollar began falling in 2002, they have been reducing investment.

Partly, businesses have been doing so because the Clinton and Bush administrations permitted the foreign government currency manipulations that have made many past investments unprofitable, and they don't expect the next administration to do any different. But there is another reason: Presidents Clinton and Bush adopted incredibly destructive capital gains tax cuts.

Clinton and Bush were among the victims of the mistaken economics idea that cutting or eliminating capital gains taxes leads to prosperity. In fact, the exact opposite is true. Cutting other taxes increases economic growth, but cutting capital gains tax rates gives taxpayers an increased incentive to consume their assets, thus making the country poorer .

The capital gains tax cuts enacted in 1997 and 2003 under Clinton and Bush have reduced American savings and investment so much that American economic growth has slowed from about 3% per year to about 1% per year.

Flat Tax Blindness

The chief advocates of capital gains tax cuts have been the proponents of the Flat Tax. Even though Steve Forbes lost the Presidential primaries when advocating the Flat Tax in 1996, his mistaken ideas are marching on.

Flat Tax advocates are a curious combination of economic insight and economic blindness. They are insightful when they claim that the capital gains tax normally double-taxes income, but are blind to the fact that only taxation of reinvested capital does so. They correctly understand that accrued capital gains represent increased future income, but they are blind to the fact that the future income is being consumed if the capital and its gain are consumed. Instead of recommending, as we do, that capital gains be taxed at the same rate as other income when capital is consumed but go untaxed when the capital is reinvested, they recommend that capital gains be untaxed in every situation, a recommendation that encourages the consumption of capital.

Flat Tax advocates contend that lowering the capital gains tax rate encourages reinvestment because investors know that their capital gains from the new investments would be subject to low rates of taxation. But they are blind to the fact that reinvesting capital mainly produces interest, dividends, rents, and/or profits, all of which are taxed at ordinary income tax rates. (Although dividends are currently taxed at the same low rate as capital gains, their actual rate is higher since they are first taxed as corporate profits.) When capital gains are taxed at a rate lower than the future income produced by reinvested capital, people pay higher taxes if they reinvest the gain than if they consume it. As a result, when capital gains tax rates are reduced, people have an increased incentive to consume their capital.

Homeowners Consume their Capital

America has not always been victimized by bad capital gains tax ideas. From 1951 to 1997, whenever a homeowner sold his or her primary residence to buy another residence, the capital gains tax was deferred until the second home was sold. As a result, our nation experienced a long real-estate boom during which homeowners kept adding to their wealth.

But in 1997, President Clinton ended that rollover, instead he reduced the capital gains tax to zero on most home sales. No longer did homeowners have any tax liability when they sold their homes without buying another. They could consume the entire sales price without paying any tax at all.

This new provision encouraged people to consume the value of their homes. Although it is hard to know whether the speculation that it encouraged started the real estate bubble, economist Thomas Palley points out that "the easing of the capital gains rules occurred close to the beginning of the bubble." During the bubble, homeowners consumed their capital by increasing the amount that they borrowed on their increasing home equity and then spending the proceeds on consumption. When the bubble burst they often found themselves facing loss of their homes and of the capital that they had invested in those homes.

Investors Consume their Capital

In 2003, congress passed President Bush's recommendation for a reduction in the capital gains tax from a maximum rate of 20% to a maximum rate of 15%, giving investors a greater incentive to realize their capital gains and consume their capital. This had the same effect upon investors that President Clinton's 1997 capital gains tax elimination had upon homeowners.

When he signed this tax cut into law, Bush proclaimed, "The top capital gains tax rate will be reduced by 25%, which will encourage more investment and risk-taking, and that will help in job creation." The opposite is true.

Bush's advisors appear not to have realized this, but corporate managers did. Their bonuses take the form of options whose value depends on capital appreciation. If they had believed what Bush said, they would have invested their retained earnings in order to increase future production and profits. Instead they opted to create capital gains artificially by buying back their corporations' own stock.

Obviously, society ought to prefer the reinvestment of retained earnings which creates job opportunities, increases efficiency, and leads to technological advance and long-term growth. Buybacks accomplish none of these benefits. They amount to a misallocation of invest able funds to consumption.

The following graph shows that stock buybacks by our nation's 500 biggest corporations began increasing in response to Bush's 2003 capital gains tax cut and have been increasing ever since.

In 2007, our 500 largest corporations were actually paying out more than they took in. They earned $587 billion in profits while paying out $589 billion for buybacks and another $246 billion for dividends . The result was a drop in investment by United States corporations, relative to peers in Germany, Japan and elsewhere. As a result of lack of investment, American economic growth slowed to a snail's pace.

Clueless Presidential Candidates

Republican voters know that something is wrong with the conventional Republican economic prescriptions. Instead of voting for the establishment Republican candidates in the primaries, they gave the most votes to political maverick John McCain and to FairTax advocate Mike Huckabee. But ever since McCain won, he has been moving quickly to adopt the Republican establishment's economic recommendations. Although he originally voted against Bush's capital gains tax cut, he quickly became a capital gains tax cut convert and even began advocating the Flat Tax as the ultimate tax reform.

Senator Obama's answer is simple but wrong. If elected, he plans to raise the maximum capital gains tax rate to 25%. Although this might stop some investors from consuming their capital, it would cause the government to consume a greater proportion of our nation's capital stock and future income whenever investors sell one stock to buy another. Even if capital stock is not sold, it would be locked into poor quality investments, making it less available to new growing sectors of the economy.

The Effective Solution

There is an effective tax reform alternative that would jumpstart the stagnating American economy. True consumption taxes (e.g. the FairTax, the Value-Added Tax, and the USA Tax) give capital gains an efficient treatment. They tax consumption, not the part of income that is saved. As a result they encourage people to add to their savings and thus build our country's future income. Consumption taxes encourage a society to accumulate capital whereas capital gains tax cuts encourage a society to consume it.

The treatment that consumption taxes give to capital gains is especially sensible. Any capital that is consumed is taxed. Any capital that is reinvested goes untaxed. Thus capital gains are taxed at the same rate as other income, but only if consumed. Gone would be the incentive for corporations to buy back their shares of stock. Gone would be the incentive for homeowners to consume the value of their homes.

Consumption tax systems are the ideal for maximizing savings and capital accumulation. In the 2008 presidential primaries, Governor Huckabee advocated completely replacing the entire income, payroll, inheritance, and capital gains tax system with a simple 23% sales tax, the FairTax. The result would be a tremendous increase in American savings and investment.

But it is also possible to incrementally improve the current income tax system. In 1951, President Truman improved the income tax for homeowners by giving them a tax deferment when they bought one home with the proceeds from selling another. Truman's idea could easily be applied to income producing assets (e.g., stocks, bonds, and rental properties).

As recent experience shows, the Flat Tax is wrong on capital gains. Lowering capital gains tax rates tends to cause investors to consume their capital instead of reinvesting it. Simply raising capital gains tax rates is not the answer because doing so locks capital into bad investments and causes the government to consume capital whenever it is rolled over into new investments.

In our just published book, Trading Away Our Future, we advocate replacing our entire current tax system with a consumption tax. But we also advocate incremental ways to improve our current system. As a first step, whoever is elected president should raise capital gains taxes to the same rate as other income is taxed, but defer capital gains taxes whenever one income-producing asset is rolled-over into another.